Once again, I am going to do an
India-China comparison. This time it is about
foreign exchange reserves and exchange rate
management. Hopefully, by the end of the article,
you will be as convinced as I am that by letting the
rupee appreciate the way it has, the Reserve Bank of
India (RBI) is doing disservice to our economic
prospects. And that Governor Zhou Xiaochuan of the
People’s Bank of China is more perspicacious than
his counterpart in Mumbai.

The graduate student’s textbook
version of open economics unfolds thus. In any
country, if the supply of dollars exceeds the demand
for dollars, the price of a dollar falls. Hence, the
price of the domestic currency vis-à-vis the dollar
rises. If, however, the central bank continues to
buy dollars, it creates demand for dollars and,
thus, keeps the lid on the domestic currency’s
appreciation, while increasing the country’s stock
of foreign currency reserves. Here lies the rub.

For every dollar that the central
bank buys, it has to release an equivalent amount of
domestic currency. That increases money supply as
well as bank credit. If the central bank is worried
about inflation, it has to ‘sterilise’ the excess
money supply. To do so, it must issue government
bonds at an attractive enough coupon interest rate
so that people willingly purchase such bonds for
cash. The cost of such sterilisation for the economy
is:

(The interest rate on domestic
government bonds x number of bonds used for
sterilisation) — (The US treasury bill rate x number
of dollars thus invested, adjusted for the
rupee-dollar exchange rate).

With reserves rising from $193
billion in end-February 2007 to $213 billion by
end-June, clearly the RBI is finding the task of
sterilisation too onerous. Thus, from 20 March 2007,
it has more or less let the exchange rate go —
intervening only once in a while to buy dollars, and
letting the rupee appreciate as it will.

In a space of 82 days between 19
March and 16 July of this year, the rupee has
appreciated by 8.2 per cent against the US dollar,
4.3 per cent against the Euro, 12.4 per cent against
the Yen, and 5.8 per cent against the Chinese
renminbi.

Does it make sense? Textbook
economist will tell you that the RBI has done just
the right thing. It had to control inflation by
tightening money supply and credit growth. And it
couldn’t do so if it had to keep on buying the
dollars that are coming in its billions and
continuing to sterilise the rupee. It wasn’t just
FII money; it was also NRI deposits and external
commercial borrowing. Faced with an unprecedented
inflow of dollars, it had to partially let go the
exchange rate.

Now consider Governor Zhou and the
People’s Bank of China. It has $1.2 trillion in
reserves versus $213 billion in the vaults of the
RBI. Net dollar inflows into China are far, far
greater compared to India. Although inflation is not
an issue, the People’s Bank also has the problem of
sterilisation — indeed more so than India’s. So, you
would expect the Chinese renminbi to appreciate at a
far faster rate against the dollar than the rupee.

What are the facts? During the same
period (19 March to 16 July 2007), the Chinese
renminbi appreciated by a mere 2.38 per cent.

China’s dollar inflows are many times
greater than ours. Everyone knows that ever since
China agreed to experiment with its own version of
the ‘float’, it has kept its currency strategically
undervalued — with its central bank intervening time
and time again to ensure a very slow, smooth, almost
imperceptible upward crawl. Everyone knows that when
the US Treasury and the IMF tell China to speed up
the process of renminbi appreciation, these august
bodies are politely told to shove off. So, China
maintains its export competitiveness, builds world
class infrastructure, attracts six times more FDI
than India, and consistently grows at double-digits
to become a $ 3 trillion economy.

Who knows the economics that matters?
Governor Zhou or the RBI? You tell me.